The Layman’s Theory of Gains from Trade

January 7, 2008 - Leave a Response

The slowing down of the American economy has stirred up a bit of a protectionist sentiment in the American population (source). It has become conventional wisdom that the growing openness of the US economy has subjected the Americans to unfair competition and cheap labor—ultimately harming the domestic economy.

I will argue that this approach is fallacious, starting from basic economic theory (There will be only a hint of simple math, do not despair).

To make the point clear as possible, we will treat a simplified economy with only two individuals, Bob and Dylan. By fate of history, Bob and Dylan happen to be cast away on the same deserted island, but are unaware of each other’s presence. Over the course of years Bob becomes a proficient farmer and Dylan excels in manufacturing linen for clothing. Time passes by as they carry on their separate lives, producing their own consumables.

Bob is able to produce 10 kilos of food or 1/5th of a kilo of linen—or somewhere in between—on average each week. Dylan on the other hand can produce either 5 kilos of food or 1 kilo of linen each week. In order to survive, Bob settles for a combination of 5 kilos food and 1/10th kilo of clothing. The same incentives drives Dylan to consume 3 kilos of food and 3/5ths of a kilo of clothing each week. Bob has the capacity to produce most food and Dylan can manufacture the most linen on a weekly basis. In economese, this is called having the absolute advantage in the production of a specific good. In this example, Bob might just as well have had the absolute advantage in producing both goods, it would not matter to final conclusion.

Observe now how much of each good, each of the two must give up in order to obtain a portion of the other good. Bob must trade off 1/50th of a kilo of linen to attain one extra kilo of food. Likewise Dylan faces the ratio of 1/5th of a kilo of linen in order to produce one extra kilo of food. In total, they consume 8 kilos of food and 4/5ths kilos of linen. We see that Bob must give up the least linen for an extra kilo of food. Economists would say, that Bob has the comparative advantage. On the other hand, Dylan has the comparative advantage of producing linen (5 kilos of food for a single kilo of linen against 50 kilos of food for a single kilo of linen!).

Then suddenly on a sunny summer’s day, Bob and Dylan find each other. Not having seen any other humans for years both are thrilled by the new company and make friends.

In the time that follows Bob and Dylan realize that their competences differ. They decide that Bob should concentrate on farming and Dylan on manufacturing. Also, they agree on sharing what they produce. After the first week, Bob has produced 10 kilos of food and Dylan has manufactured 1 kilo of linen. Clearly Bob and Dylan do better by working together, than each on his own.

Although this example may seem overly simplified, the principle of gains from trade applies to large economies just as well. A country’s endowment of resources should be used on producing the goods that has the smallest trade-off. In economese; a country should take advantage of it’s comparative advantage, and obtain other goods by trade.

The lesson is; trade can make everyone better off. The underlying economic principle was first described by David Ricardo in the 18th century, but remains as true as ever.

Protectionism hurts economic well-being.

Sincerely,
Thanas Enlarded

listen, world!

January 6, 2008 - Leave a Response

We are three students from Copenhagen who have decided, admist our final exams, on a cold and wintry January night to create a medium wherefrom our voice may be heard, with the solemn wish that one day, ages hence of our walk on this fair earth, our word may stand and alight the lives of others who think themselves similar. What we shall say and express stand yet undefined but we hope, in the fullness of time, that some form of purpose and meaning may develop from our words of wit, humour and despair. ‘The written word is choicest of relics’ and we will venture to make this blog an expression of our time, in our world and in our very souls.

Most sincerely,

Thanas Enlarded, Raja Car Bids Go and Aerial Tzar Sunned

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